Unit 7: The Firm and its Customers
Jack Cohen's motto, “Pile it high and sell it cheap,” guided Tesco from its beginnings in 1929 to becoming the UK’s
leading food retailer with a 25% market share. This strategy of maintaining low prices attracts high customer
volumes, generating substantial total profits despite low margins per item.
In contrast, firms like Apple pursue a high-price strategy, leveraging premium pricing for iPhones and iPads to
achieve significant profit margins of around 50%. This approach contrasts with Tesco’s lower margin of about 5%.
Success for companies like Lego and IKEA has involved anticipating customer needs and establishing strong brands.
Lego, founded by Ole Kirk Kristiansen, focused on high-quality, buildable toys, while IKEA, founded by Ingvar
Kamprad, aimed to provide quality furniture at affordable prices. Apple’s Steve Jobs emphasized the importance of
innovation and speed by anticipating future customer desires.
These companies differentiate themselves from competitors, creating a competitive advantage or "moat" that
defends them against market entrants. Innovation and efficient operations, such as LEGO’s global distribution center
or IKEA’s flat-pack furniture (reducing storage and transportation costs), contribute to cost advantages and higher
quality.
Firms may also leverage labour cost-saving strategies, as this accounts for
a high share of firm’s costs, including outsourcing production to lower-
wage countries or adopting gig economy labour. Conversely, high-wage
strategies can recruit, motivate and retain specialized talent.
Regulations and taxes also impact firm decisions. While regulations can
level the playing field, firms might seek to minimize their impact through
lobbying to reduce tax or relocating to less regulated areas.
Figure 7.1:
Overall, firms must balance pricing, product range, innovation, and The firm’s
operational efficiency to maximize profits and maintain competitive decisions.
advantages.
Maximizing Profit: Analysis of Pricing and Quantity Decisions
To determine the optimal price for a product, a firm must balance the trade-offs between revenue and cost to
maximize profit.
Profit Calculation: Profit is determined by subtracting the total production costs from the total revenue. For a firm
producing a cereal with a unit cost of $2, if the firm produces Q pounds and sells them at a price P, the profit can be
calculated using: Profit = (P - 2) × Q
, Isoprofit Curves (equal profit): These curves show how combinations of price and quantity that yield the same level
of profit. Also, thought of as a firm’s indifference curve: the curve joins together all the combinations of goods that
provide a given level of utility to the firm. Higher isoprofit curves represent higher profit levels, and they slope
downward. This reflects that higher prices generally result in lower quantities sold to maintain the same level of
profit, and vice versa.
The horizontal line at P = $2 indicates zero profit, as the selling price equals
the cost.
The Lowest Isoprofit curve shows:
A profit of $10,000 can be achieved by selling: 10,000 pounds at $3 per
pound, 5,000 pounds at $4 per pound, or 2,000 pounds at $7 per pound.
The Highest Isoprofit curve shows:
Similarly, to make $60,000 profit: 60,000 pounds can be sold at $3, 20,000
pounds at $5, or 10,000 pounds at $8.
Figure 7.2b: Isoprofit curves for a firm with unit cost of 2.
Figure 7.3: Estimated
Demand Curve: The demand curve shows the number of units of a good demand for Apple
that buyers would wish to buy at any given price. It is downward-sloping, Cinnamon Cheerios.
indicating that as price increases, the quantity demanded decreases. This is
a constrained choice problem (a decision-maker chooses the values of one
or more variables to achieve an objective (maximizing profit, or utility)
subject to a constraint that determines the feasible set (such as the
demand curve, or budget constraint) that firms must consider when setting
prices.
Figure 7.4a: The profit-maximizing choice of price and quantity
for Apple Cinnamon Cheerios. To maximize profit, you should select a combination of price (P) and quantity
(Q) that lies on the highest isoprofit curve within the feasible set, which is
determined by the demand curve. Although selling 8,000 pounds at $3.25 is
feasible, increasing the price to a point on the demand curve would yield
higher profits.
(8,000, 3.25)
The optimal profit-maximizing point is found where the demand curve is
tangent to the highest isoprofit curve, at point E. Here, the recommended
strategy is to set the price at $4.23 and sell 15,000 pounds of cereal.
Figure 7.4b: The profit-maximizing choice of price and
quantity for Apple Cinnamon Cheerios.
Another way to approach profit maximisation is shown in figure
7.4b where profit is calculated at each point along the demand
curve to identify where it is highest.
Economies of scale: the cost advantages of large-scale
production
By plotting profit along the demand curve, we see that it increases
with quantity up to a maximum of $33,450 at point E, where
Q=15,000 and P=4.23. Beyond this point, profit declines as more
cereal is sold at lower margins. Profit is zero when price equals the
unit cost of $2, and it becomes negative if the price drops below this
cost. The lower panel confirms that profit is maximized at point E,
where the demand curve is tangent to the isoprofit curve.
While most firms are small, large firms dominate employment in
wealthy economies. Firms become large because they can
produce at lower costs per unit, which boosts profitability. This
